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April 11, 2013

Cyprus Bailout Shockwaves Travel Beyond Eurozone

When Cyprus approached the International Monetary Fund last summer to say that it might need a bailout, it had no idea what lay in store.

Already in trouble from its heavy purchases of Greek bonds, only a few years ago Cyprus had had a humming economy, fed in large part by a financial sector that thrived on substantial deposits from, among others, Russians who had made their money after the breakup of the Soviet Union and who parked billions in accounts and shell companies housed by Cyprus’s relaxed atmosphere.

However, the Greek crisis hit Cyprus hard. Its financial sector held assets eight times the size of its economy, and after the “haircut” imposed on those holding Greek bonds, the situation worsened as some of those large depositors began to move their money out of the country’s banks. Cyprus drew on Emergency Liquidity Assistance from its central bank to the tune of 9 billion euros, but after the country’s February elections the European Central Bank informed the new government that it would cut off additional ELA unless Cyprus worked out a bailout deal.

The deal finally offered in March shocked not just Cypriots, but people throughout the Eurozone and beyond. The troika—the European Union, the IMF, and the ECB—determined that for Cyprus to receive a 10-billion-euro bailout, it must contribute 5.8 billion euros to its own rescue. Since Cyprus, unlike Greece in earlier days, did not have many bondholders from which to get funds, the remaining option was to take the money from the bank’s depositors—something that had never been done.

Cyprus was the fifth nation to receive a bailout, but no other nation got hit with the terms that Cyprus did: originally all depositors were expected to help pay for the rescue, with small depositors paying a 6.75% levy and large depositors, with accounts over 100,000 euros, paying even more. That was so distasteful Cyprus tried, but failed, to get a helping hand from Russia, the source of so much of its money. Cyprus’s parliament voted down the deal, which then was revised so that only depositors with accounts over 100,000 euros were to be hit.

Still, the notion that small depositors with guaranteed savings could be expected to pay for a bailout at all raised fury in Cyprus. Large depositors, of course, weren’t happy either, especially since they could no longer move funds out of the country under the newly imposed capital controls designed to prevent runs on the banks.

Cyprus was a tax haven, and perhaps it was inevitable that there would be trouble once regulators began to pursue tax evaders and the institutions that supported them. After all, the U.S. brought down Switzerland’s oldest bank, Wegelin, that had been doing business based on privacy for 272 years. It also brought Switzerland to the negotiating table in an attempt to come to terms for the rest of its banks.

However, the trouble came, not from the U.S., but from Germany, which insisted that depositors had to pay for the bailout. Why? In part because Cyprus has a reputation for lax financial rules, despite the fact that it has in place all the regulations that were required for its entry into the Eurozone. It is one thing to have regulations, and entirely another to enforce them.

The facts that depositors with supposedly insured accounts were targeted, however briefly, and that large depositors are now on the hook for as much as 60% of their funds, have led to concerns elsewhere in the world, not just the Eurozone, that it could happen again—and to them. In fact, the U.K. has already moved to reassure its depositors that their money is safe.

But fear that this will be the way of future rescues can be credited at least partly to Dutch Finance Minister Jeroen Dijsselbloem, who took over in January as head of the Eurogroup of eurozone finance ministers. Dijsselbloem said that, “if necessary,” depositors should be among those who should be asked to recapitalize banks. He backtracked later on, saying that Cyprus was a unique case and that each solution was tailored to the circumstances of its crisis, but the Rubicon had already been crossed. That was made clear when Jyrki Katainen, prime minister of Finland, later spoke out in favor of owners and investors (depositors) taking losses if a bank failed.

While the press has been full of speculation from various experts about another such “unique” case and where it might occur—everywhere from Greece to Italy to Spain to Slovenia has been mentioned, with equally dire warnings about the U.S., U.K., and New Zealand—others are more sanguine. John Blank, chief equity strategist for Zacks, who earlier in his career worked for the chief economist of the IMF, said that other countries have different issues, which would make it unlikely that such a situation would spread.

Pointing out that other tax haven countries would benefit from Cyprus’s downfall—indeed, Malta and the Cayman Islands are reportedly among those already approaching the wealthy in Cyprus to offer their services—Blank said that a more likely avenue for the spread of trouble would be any social unrest occurring in Cyprus as a result of the bailout terms. He sees high unemployment and the apparent lack of sympathy on the part of bailout institutions as more of a threat.

“It’s the misery of these countries,” Blank said, as well as the need for stimulus packages large enough to work. “That to me is the real problem. Cyprus is showing us that Europe does not have a growth strategy; it has a debt reduction strategy, but not a growth strategy. It has to get a whole lot worse before it gets better. The bureaucrats just don’t get it yet,” he said.

That said, Blank said that both Spanish and Italian yields were higher in the wake of the Cyprus crisis. Italy, with its current government instability, is the more likely target for any possible contagion. “If Italian election uncertainty drags on and people start to worry, that’s how it could happen,” he said. If Italian depositors are spooked enough by what happened to Cypriot depositors, further destabilization could nudge them into a run on Italian banks, which could spur another crisis.

One aspect of the Cyprus crisis that has perhaps come as something of a surprise is the rise of the virtual currency Bitcoin, which added 360% over the past month in the face of the Cyprus crisis, currency worries, and conversations on social media. A virtual currency could offer an escape route past capital controls, and interest in the concept has risen substantially across the eurozone with the escalation of the Cyprus situation. Spain in particular was noticed to experience a spike, albeit a small one, in downloads of Bitcoin mobile apps as the Cyprus situation worsened. Perhaps more telling is the fact that on March 16, Bitcoin Google searches soared in Spain.

However, as if to prove that nothing is failsafe, Bitcoin was hacked the first week of April and its price lost 20% overnight, proving that not just the virtual currency itself but its reputation is both still somewhat risky. In addition, analysts have been warning that Bitcoin’s heady rise could be a bubble—and we all know what eventually happens to bubbles…

Still, the first ATM for Bitcoin is planned for Cyprus, with others apparently destined for Spain, Greece, and Italy. And for those interested in such things, there is even a Bitcoin hedge fund—but it’s in Malta.